Time Again For Value Investing Through Berkshire Hathaway

| About: Berkshire Hathaway, (BRK.B)
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As a value-driven and at times contrarian oriented analyst and investor, I have the utmost respect for Warren Buffett and Berkshire Hathaway (BRK.A). The company has offered investors one of the highest and consistent returns for countless years. After a temporary drop in ROE and ROA last year, I sense that the company's net profit is growing again this year. Thus, it may be a good time for a value investor like me to take a hard look on the stock again. Some catalysts that I think will contribute to the growth of the company's revenue, net profit and stock price over the next several quarters are as follows:

1. Opportunities of outsized gains from arbitrage of gross imbalance on asset valuations of small/mid cap stocks worldwide:

Before we start, let's be straight on one thing: Berkshire Hathaway (BRK.B) has piles of cash right now. Even after its last big purchase of oil additive maker Lubrizol last year and recent share buyback, it still has over $37 billion of cash as of 12/31/2011. One source of highly lucrative incremental profits comes from arbitrages of grossly undervalued Chinese small/mid cap companies with valuable assets, robust business operations, sustainable profits, and high growth potentials.

Mr. Buffett has never lost sight on China and other emerging markets.

Not many people actually are aware of this: Mr. Buffett has a track record of being 100% value-focused and unbiased and not hesitating to take positions in Chinese stocks when rare opportunities of outsized gains exist. Two best examples are PetroChina (PTR) and BYD (a leading electric car maker traded on Shenzhen and HongKong exchanges).

His has just turned very bullish in China again and hinted on being extremely interested to go shopping on undervalued and/or high-growth Chinese stocks lately.

Many Chinese small/mid caps are currently trading at 70% or more discount compared to their peers trading on the exchanges in the U.S., Shanghai, Sheng Zhen, Hong Kong, or Taiwan. Even assuming that BRK pays in average 50% premium over current prices of many good Chinese small caps, there are still plenty of room for gain on arbitration. For a company like Berkshire, it can probably reap gains from simply acquiring beaten down Chinese small caps and add their net profits to Berkshire's income statement. For example, several Chinese small caps in the oil industry are currently trading at only about two times of their annual net incomes. Suppose Berkshire spends $600 million to buy a small cap with annual net profit of $100 million, Berkshire will add $100 million additional net profit to its income statement from this acquisition. Since Berkshire is currently valued at over 19 times of its net profit, if it's P/E multiple stays the same this $100 million additional net profit will give the Berkshire $1.9 billion of additional market capital. In other words, Berkshire can pay a price of six times of net profit to acquire a Chinese small cap oil company and immediately add 19 times of its net profit to BRK's market capital, immediately reaping 216% gain (19 divided by 6) on a M&A deal.

In addition to China, there are also many immediate arbitration/revaluation opportunities in other emerging markets such as Brazil, India, Africa, etc. that were also greatly impacted by capital withdraw from emerging markets over the past couple years. For example, there are numerous reports on Buffett being interested in Brazil assets.

I estimate that BRK may spend $5 billion in M&A deals for small/mid caps in emerging countries over the next 12 months, with majority of deal making in China. For this chunk of investment, a blended return of 30% or more per year for the first two years (35% for Chinese small/mid caps and 25% for small/mid caps in other emerging economies) is very achievable.

2. Unique investment opportunities from special situations and demand/supply imbalances:

The second source of outsized returns comes from big caps currently dumped by investors due to special geopolitical or economic events such as the biggest ever earth quake in Japan last year, European debt crisis, or unrests in Middle East or other parts of the world. These special situations create rare opportunities to buy big companies that are expected to benefit from these local events over the long run. Look no further than its acquisition of Lubrizol last year for a perfect example.

First of all, Lubrizol's products are fuel additives that enjoy strong long-term demand and are extremely resistant to inflation. Lubrizol has strong ability to pass through increase of material costs to its customers. In 2010, the last full year before it was acquired by Berkshire, Lubrizol's COGS increased by 10%, but the company passed almost all the increase in costs to consumers and kept its net profit margin almost intact. Because of this reason, Lubrizol's margins are very stable. Evidences of its strong profitability: Lubrizol delivered a gross margin of 33% and return on equity of 34% in 2010.

Secondly, Lubrizol is in a position to profit on strong growth of China and other emerging countries. Two-thirds the company's revenues in 2010 came from outside the U.S. In addition, 40% of its plants and other assets are located outside the U.S., including a big factory being constructed and scheduled to begin production later this year in China. Most economists think that demand for oil products in China, India, Brazil, and many other emerging economies will continue to enjoy a high rate of growth over the next five to ten years.

Last but not least, Lubrizol will see extra demand on its product from re-surging demand for oil and related materials from the earth quake in Japan last year. Rebuilding the damaged regions take countless work hours of vehicles and machines, all of them need tons of petroleum fuels and lubricants. Talk about perfect timing and bottom hunting. Warren Buffett once again showcased his unbeatable skills of value investing. Berkshire's last 10-K report showed that even though Lubrizol's earning was only included in Berkshire's income statement after September 16th last year, Lubrizol already helped Berkshire to realize a 23.4% YOY increase in net earnings for "Manufacturing, service and retailing" group of its holdings.

Opportunities like this will keep on surfacing during this unsettling time of the world. I estimate Berkshire may deploy $10 billion to $15 billion of its cash piles over the next 12 months on this type of high return/low risk big M&As and drive 15% - 20% annual return on investment form these purchases over the next few years.

3. Strong Synergies from vertical/horizontal integrations:

This is not a stand-alone catalyst but an additional source of earning multiplier on top of the previous two catalysts. Because of the diversity of its current holdings, Berkshire has ways to integrate any newly acquired companies with its existing subsidiaries horizontally to generate additional sales through cross marketing/sales or vertically to cut costs along supply chain. For example, Lubrizol and MidAmerican Energy Holdings Company, another current holding of Berkshire, can benefit from a Chinese petroleum wholesaler's distribution network, business connections, and know-how of the energy market in China.

Another holding of Berkshire, the Marmon Group, has diversified operations in China, Brazil, and Japan and can benefit from adding related businesses of other companies in these countries to its repertoire of service and products.

Of course, we need to be careful about double counting gains here. To be conservative, I would count these synergies between Berkshire's existing holdings and newly acquired companies as added guarantees of the above normal returns that Berkshire would be able to generate from these acquisitions.

4. Strong Long-Term Technical Trend with A Strong Support:

I am not a fan of investing basing on technical analysis, but I do want to note that Berkshire does show case one of the strongest and most stable long-term technical support I have ever seen. Take at the 20 year chart below and you'll notice that the stock only walked considerably below 200-day line in three periods including two market crashes in 2008 and last summer. At all remaining periods, 200-day line provides almost unbreakable support for the stock. In fact, even 100-day and 50-day lines provided quite strong support most of the time too.

(Click to enlarge)

Source: Yahoo Finance.

Look closer to 200-day line and you'll notice that the 200-day line repetitively exhibits a pattern of curving to the upside following a section of linear upward trending line. It other words, the stock has a characteristic of having second degree polynomial term in its upward trending line. Currently, as the chart below shows, 200-day line, 100-day and 50-day line have all been linearly trending up for over a month, with MACD sitting on positive territory, indicating a high possibility of faster appreciation in the next few months.

(Click to enlarge)

Source: Yahoo Finance.

5. Share Buybacks:

Last September, Mr. Buffett announced that Berkshire would start buying back shares at prices up to 110% of their book value. Currently the buyback is not in action because company's market capital has already exceeded 110% of its equity value on book. However, as the company enjoys fast growth in revenue, net profit, and equity in the coming quarters, its market capital may fall below 100% of book value again soon. Moreover, there is no reason why Mr. Buffett will not raise the threshold for share repurchase if he sees faster growth on horizon.

On account of the aforementioned catalysts, I can easily see the company's revived earning growth and stock appreciation over the next several quarters.


Before I end this article, I'd like to talk about the company's two classes of stocks. Some people might not know the difference between the two classes of stocks of Berkshire Hathaway and wonder which one is a better investment. In fact, some people might not even know Class B shares and still think that the only stock that Berkshire Hathaway offers is Class A shares that costs more than $100K per share. The fact is: the difference between the two classes of stocks is minimal and not important to most investors. The most important relationship between the two shares is that each Class A share has 1,500 times claim to the company's assets and earning as each Class B share has. The only two other differences are that each Class A share has 10,000 times voting right of a Class B share and that a Class A share can be converted to 1,500 Class B shares any time at the holder's option. Except for few investors who want to influence the company's board elections and other critical decisions, the additional voting right of a Class A share really doesn't mean anything. Theoretically Class A shares can trade at an excessive, unsustainable premium over Class B shares. In practice such phenomenon rarely presents. Personally I prefer B-shares because they give me finer granularity in my position. For example, suppose I want to invest within +-1% of $200,000 in the company, there is no way I can do it with Class A shares.

Disclaimer: Please see my standard disclaimer for all my articles here.

Disclosure: I am long BRK.B.